EC3115 Monetary economics
Summer 2022
Section A
Answer all SIX questions from this section.
Indicate whether the following statements are true or false, or uncertain and give a short
explanation. Points are only given for a well reasoned answer.
1. Credit market imperfections can deepen economic downturns.
2. Central banks’ inflationary biases arise due to political interference.
3. Classical dichotomy implies monetary policy effectiveness to stabilise real output fluctu
ations.
4. Baumol-Tobin’s inventory model can explain why firms hold significant cash balances.
5. Base money (or high powered money) is the total money supply.
6. Empirical Phillips Curve is shown to be stable and thus can be used to conduct monetary
policymaking.
Section B
Answer TWO out of THREE questions from this section.
7. Assume that the banking sector is described as follows:
D = d0 − d1(i − iD)
L = d0 + l1(i − iL),
where L stands for demand for bank loans, D stands for supply of bank deposits, iL the
loan rate, iD deposit rate and i is the market interest rate. Assume that banks do not
have operating costs and are not required to hold reserves and that d1 > 0, l1 > 0.
(a) (12 points) Calculate the competitive equilibrium. Illustrate the equilibrium in a
diagram. How do your results change when the government sets deposit rates equal
to iD = a, with a < iL. Provide intuition.
(b) (12 points) Now suppose that government introduces a mandatory reserve ratio,
r
∗
, such that R = r
∗D assuming that the central bank does not pay interest on
reserves. How do your results change? What are the implications of such a reserve
ratio policy on prices and quantities? Provide intuition.
(c) (8 points) Following the Global Financial Crisis in 2008 interest rates reached zero
percent. Sometimes, it is suggested that the reserve ratio policy can be an
alternative to targeting interest rates or monetary aggregates. Discuss pros and cons
of utilising reserve ratios as a policy instrument.
8. Suppose that the economy is characterised by the following aggregate supply (π) and
aggregate demand (y) equations.
πt = yt + aπt−1
yt = yt−1 − bit + t
where y is the output gap, π is the inflation and i is the short term nominal rates the
monetary authority controls. a and b are structural parameters of the model. The
persistent output gap equation is subject to a shock t that is not observed in period t.
This shock is distributed i.i.d. normally and ∼ (0, σ2
) and its statistical properties are
known to the monetary authority. Suppose that the monetary authority has an expected
loss function given by
L
e = E[(πt − π
∗
)
2 + (yt − y
∗
)
2
]
Note that the monetary authority cares both about inflation stabilisation around a target
rate π
∗ = 0 and output stabilisation around a target rate y
∗ = 0. Having this structure
in mind answer the following questions.
(a) (13 points) Suppose the economy is subject to only additive shocks ( ). How should
the monetary authority set the interest rate? What does the concept of certainty
equivalence mean? Comment also on the relevance of the output persistence in the
determination of the policy response.
(b) (13 points) Ever since the work by Brainard (1967) it is understood that structural
relationships between key macroeconomic variables governed by the structural pa
rameters may change over time.
yt = yt−1 − btit
The policymaker knows from which distribution b parameter is drawn. Let b ∼
N(bb, σb
2
). How do your results change? Interpret carefully the optimal interest rate
policy response. What does the coefficient of variation represent?
(c) (6 points) In January 2022 the Bank of England started to raise the target interest
rate due to inflationary fears. What else could the economic policymaker do to bring
down the UK inflation?
9. Observing significant changes in the way production is taking place, some commentators
believe that economic performance changes associated with Covid 19 can be interpreted
as an outcome of an aggregate supply shock such as online working practices. They also
believe that this may have long lasting implications on economies. Others believe the
impact of Covid 19 will be temporary and that observed changes should be considered
as an outcome of an aggregate demand shock.
(a) (12 points) Assuming that behavioral changes during the Covid 19 era are driven
by an aggregate supply shock and by using an appropriate model, provide
predictions for key business cycle variables.
(b) (12 points) Assuming that behavioral changes during the Covid 19 era are driven
by an aggregate demand shock and by using an appropriate model, provide
predictions for key business cycle variables.
(c) (8 points) Assuming that behavioral changes during the Covid 19 era are driven
by a mixture of aggregate demand and supply shocks and by using an appropriate
model, provide predictions for key business cycle variables.